A loss of 20%
requires a 25% return to recover;
while a 50% drawdown (as seen in 2008 and 2009)
while a 50% drawdown (as seen in 2008 and 2009) requires a 100% increase to recover the loss back.
For Financial Advisors Only
Minimising drawdowns across
markets
Chapter Three
A Guide to
Defensification
En Garde!
A defensive approach, focused on drawdown
The global financial crisis and years of monetary experiments by the world’s central banks have had a profound effect on yield: income is harder to come by and investors are required to take on more risk to find it.
Moreover despite the last few years having eventually produced decent total returns, the lower income offered by asset classes has at times been completely offset by the relatively larger capital losses they have experienced during periods of drawdown.
Reducing risk to protect the portfolio from drawdowns is a primary focus of the Investec Diversified Income Fund. Doing so allows the fund to minimise losses and so compound positive returns.
100%
82%
54%
33%
18%
11%
5.2%
-50%
-45%
-35%
-25%
-15%
-10%
-5%
Required gain to cover loss
Portfolio loss
Drawdowns
Drawdown refers to the peak-to-trough decline of an investment and is an important risk metric allowing investors to assess the downside risk and the ‘upside’ required to reverse it. The ‘law of numbers’ allows us to illustrate the importance of avoiding losses by showing that a loss of 25% requires a 33% return to recover it. Meanwhile, a 50% drawdown - as seen in markets between 2008 and 2009 - requires 100% increase to recover that loss back to zero.
The possible impact of future events should be thought about. If these events (for example geopolitical tensions or referendums) are determined to have a significant likely impact on the portfolio, and their probability is uncertain but material, then exposure to these can be partly hedged out to reduce unrewarded volatility.
Event risks
Investors should monitor the market environment for signs of increased risk and when this occurs they should reduce market exposure even if this means sacrificing short term gains. This decision should be based on a combination of quantitative and qualitative analysis.
Systemic risks
Amid today’s low yield environment, stretched asset class valuations, and rising geopolitical and monetary policy risks, it is important that the method of how and when to shift the focus towards downside protection is consistent, practical and reliable.
We believe portfolio risk should occasionally be dialled down temporarily for two reasons.
be dialled down?
When should portfolio risk
Stress testing: Prepare for the worst and respond quickly
Stress testing against both of the above provides us with an understanding of the upside or downside risks of our positions. As financial market stress or event risks develop, the risks to drawdowns are heightened, reducing the attractiveness of the risk/reward environment. In such situations, the risk taken by the strategy can be ‘reigned in’.
By monitoring both such risks systematically, we can scale down risk to temporarily protect the portfolio. Having built the portfolio with a thorough understanding of the risks of individual positions, this can be done with greater efficiency and precision.
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Risk statistics vs. income and defensive competitors
Performance over 10 worst days for equities
Performance of DIF vs. gilts on the 10 worst days for bonds
(price change in bond index)
Performance of Diversified Income Fund vs. every negative monthly equity return
Multi-layered management of risk
“Since inception, the Fund has been able to outperform both gilts and global equities during every single one of their respective worst days of performance”
Jason Borbora
Portfolio Manager, Investec Diversified Income Fund
Portfolio structure, position selection and tactical risk management all help to limit drawdown. The net result of consistently applying these principles helps to produce a strategy with better risk-adjusted returns, ultimately aiming to deliver on the fund’ return objective for investors.
Considering the current yield environment, stretched asset class valuations, and rising geopolitical/monetary policy risks makes this drawdown focus particularly important.
By taking an approach which seeks to capture returns to the upside and guard against the downside, the Investec Diversified Income Fund has been able to skew the returns in a positive direction and compound returns in challenging markets, as can be seen in the chart below.
Similarly, and by again ensuring a portfolio is not reliant on just one source of returns, the Diversified Income Fund has shown how, even in the very worst instances of market distress, it can withstand bouts of high volatility and minimise losses. Since inception, the Fund been able to outperform both gilts and global equities during every single one of their respective worst days of performance. These are very short time periods and so not something the fund would explicitly seek to achieve. nevertheless, it is very difficult to predict when any single day of losses might occur and so this is a decent
demonstration of how the fund’s natural set-up is defensive.
Aside from bottom-up resilience and structural diversification of a portfolio, which we have discussed in this eBook previously, there are a host of tools available to control risk during periods of market weakness. Selling equity futures to reduce equity market exposure, buying or selling bond futures to adjust duration, and hedging currency exposure using forward foreign currency contracts are all liquid and scalable methods of controlling risk when the market environment shows signs of deteriorating. But these tools’ efficiency is only maximised when applied to a portfolio whose risk exposure is also appreciated.
This is why the Diversified Income Fund places risk management at the core of its strategy. By building a portfolio from the bottom-up, rather than through blunt blocks of beta, thereby achieving ‘true’ diversification of risk and income, the Fund aims to provide a defensive stance in all market scenarios.
The result of implementing this approach since the fund launched in September 2012 has been positive. The Fund has outperformed the MSCI World Index in all but two of its 18 negative return months since 2012. In fact, the Fund produced positive returns in half of the index’s negative periods as a result of individual securities in the portfolio frequently outperforming.
-6%
-7%
-5%
-4%
0%
-1%
1%
-2%
2%
-3%
3%
31.10.16
30.06.16
29.02.16
29.01.16
31.12.15
30.11.15
30.03.15
31.08.15
30.06.15
31.03.15
30.01.15
31.12.14
30.09.14
31.07.14
31.01.14
30.08.13
28.06.13
31.10.12
1 month % change of MSCI World US$
1 month % change of Investec Diversified Income
Source: Morningstar, 31.10.17, based on NAV to NAV (inclusive of all annual management fees but excluding any initial charges) of I Acc, monthly data, gross income reinvested, in GBP. Structural diversification.
Past performance should not be taken as a guide to the future, losses may be made.
0.0%
-0.5%
0.5%
-1.0%
1.0%
-1.5%
1.5%
14.09.12
03.01.17
12.09.17
03.06.15
15.12.16
15.12.15
05.05.15
29.04.15
09.09.16
02.01.13
1 day change of UK benchmark 10 year DS. Govt. Index
1 day change of Investec Diversified Income
-2%
-3%
-1%
-4%
0%
-5%
1%
15.10.14
22.09.15
21.08.15
01.09.15
08.02.16
20.06.13
27.06.16
20.01.16
24.08.15
24.06.16
1 day change of MSCI World US$
1 day change of Investec Diversified Income
Source: Morningstar, 31.10.17, based on NAV to NAV (inclusive of all annual management fees but excluding any initial charges) of I Acc, monthly data, gross income reinvested, in GBP.
Past performance should not be taken as a guide to the future, losses may be made.
*Source: Morningstar, 30 September 2017, NAV based, gross of UK basic rate tax (inclusive of all annual management fees but excluding any initial charges), in Pound Sterling. Retail share class net performance in GBP since inception: 3 September 2012. UK Equities = FTSE All Share TR GBP.
The list of competitors is frequently reviewed and is based on our Multi-Asset team’s analysis of the competitor landscape. The defensive peer group average is based on all multi-asset funds within the IA Targeted Absolute Return sector. The income peer group average is based on all funds from within the IA mixed Investment 0-35, 20-60, 40-85 shares and specialist sectors
which include ‘income’ and/or ‘distribution’ in their fund names and are over £100m in size.
Past performance is not a reliable indicator of future results, losses may be made.
-6%
-8%
-4%
-2%
6%
4%
8%
2%
10%
0%
12%
-10%
-12%
Income
Defensive
FTSE AllShare TR GBP
Max drawdown average
Up/down ratio average
Standard deviation (annualised)
Investec Diversified Income
Conclusion
1 Source total return: Morningstar, dates to 30.11.17. Source fund performance: Morningstar, 5 years ending December 2016. Performance is net of fees (I Share class, NAV based, including ongoing charges, excluding initial charges), gross income reinvested (net of basic rate UK basic rate tax pre 5 April 2016), in GBP. If the share class currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Since inception: 3 September 2012, prior to this date, the fund was called Managed Distribution, and was managed to a different investment objective.
2 Yields quoted are for the I Inc-2 share class of the Fund. The yield reflects the amount that may be distributed over the next 12 months as a percentage of the Fund’s net asset value per share, as at the date shown, based on a snapshot of the portfolio on that day. Where there is a yield number in brackets, it is calculated in the same way, however, as the charges of the share class are deducted from capital rather than income, it shows the level of yield had these charges been deducted from income. This has the effect of increasing the income payable whilst reducing capital to an equivalent extent. Yields do not include any preliminary charge and investors may be subject to tax on their distributions.
The challenge of generating a high and sustainable investment income while simultaneously protecting investor capital has never been more difficult.
Thus, defensification is a powerful fund attribute at a time when asset class returns appear slim, providing the managers of the Investec Diversified Income Fund with a number of tools to not only help them control downside risks from the outset, but to maintain low volatility as well.
Though it may go against traditional multi-asset investing norms, by building from the bottom-up and diversifying the assets we invest in by their behaviours rather than labels, the team is able to place ‘defence’ at the heart of the strategy and properly stress-test portfolios against a variety of market environments.
The last 5 years, despite producing impressive overall returns, has seen some challenging market performance at varying points and across asset classes. August 2014 to January 2016 saw a 30% drawdown in Emerging Market Local Currency debt, May 2015 to February 2016 saw a near 20% drawdown in global equity markets, and US treasuries saw a 6% drawdown from April to August 2013.
Against this background, the net result of consistently applying defensive principles has seen the Investec Diversified Income Fund deliver a resilient and better diversified portfolio that has delivered its target yield of between 4%-6%,with the lowest drawdown* versus its peers and the FTSE All Share Index, as can be seen in the chart above. Going forward, by taking an approach that continually looks to guard against downside risks, we anticipate the fund’s lower-volatility and outcome-focused strategy will have the potential to continue to perform in challenging markets.
*Performance targets may not necessarily be achieved and are not guaranteed, losses may be made.
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This communication is being provided for informational purposes for discussion with institutional investors and financial advisors only. Circulation must be restricted accordingly. Nothing herein should be construed as an offer to enter into any contract, investment advice, a recommendation of any kind, a solicitation of clients, or an offer to invest in any particular fund, product, investment vehicle or derivative.
The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. Past performance is not a reliable indicator of future results.
Specific risks
Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivative counterparty: A counterparty to a derivative transaction may fail to meet its obligations thereby leading to financial loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses. This may lead to large changes in value and potentially large financial loss. Developing market: Some countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises. Multi-asset investment: The portfolio is subject to possible financial losses in multiple markets and may underperform more focused portfolios.
Bond and Multi-Asset funds may invest more than 35% of their assets in securities issued or guaranteed by an EEA state.